The month of December finished like all of 2022: with losses for stocks and bonds. The S&P 500 lost 5.76% for the month and 18.11% for the year. The Nasdaq lost 8.67% for the month and 32.54% for the year. U.S. mid caps and small caps lost 5.54% and 6.71% in December while they lost 13.06% and 16.10% through all of 2022, respectively. International markets actually outperformed in December, primarily due to a weakening dollar, but they were still flat (developed markets gained 0.11%) or slightly negative (emerging markets lost 1.35%). Developed markets lost 14.01% in 2022 while emerging markets lost 19.74%. The one shining corner of the stock market in 2022 was the energy sector, delivering a 65.7% return; the next best-returning sector was utilities with a 1.6% return.

The bond world wasn’t much better, and in fact, it was worse if you’re considering bond market performance against its own history. The main bond index in the U.S., the Bloomberg U.S. Aggregate, lost 0.45% in December to cap off a 13.01% decline for 2022. This is the worst calendar year performance since the index was created in 1976; by comparison, the second worst year was 1994 when the index lost only 3%. The high yield bond market, as measured by the Bloomberg U.S. Corporate High Yield index was also down significantly in 2022 although it outperformed the higher-quality Aggregate index with an 11.04% decline. This relative outperformance can be primarily attributed to the strength in the energy sector, which comprises a large proportion of the high yield market. The reason for this historically painful year in bonds was the steep rise in interest rates across the yield curve. A 3-month U.S. Treasury began 2022 yielding 0.08% but finished yielding 4.42%. The 2 year U.S. Treasury went from 0.77% to 4.36%. The 10-year U.S. Treasury from 1.63% to 3.88%. The yield curve inverted in 2022; the most commonly referenced spread being the difference between the 2- and 10-year Treasury yields; in early December the 2 year Treasury was yielding as much as 0.84% more than the 10 year Treasury, although this gap closed to 0.53% by the end of the year. As we have written about extensively, yield curve inversions are seen as a reliable indicator of looming recessions.

Investors undoubtedly would like to put the experience of 2022 behind them, but there is a strong case to be made that the bear is still lurking around the picnic. An all-time high 44% of economists surveyed predict a recession will occur in 2023. Investor sentiment is still at historically low levels. The amount of protection investors are seeking on their equity exposure, as measured by the CBOE Total Put/Call ratio, is at an all-time high by a significant margin. Regular readers of our newsletter will know why: even if inflation is beginning to subside, the Fed’s inflation-fighting policy of tightening monetary conditions—ending its mortgage buying program and hiking its Federal Funds Rate at a rapid clip—are almost certainly going to slow down the U.S. economy. The main question is to what degree will the economy slow. Will Fed Chair Jerome Powell ultimately thread the needle to a soft landing by bringing inflation to acceptable levels without spurring a large jump in unemployment and a decline in corporate earnings? Or will it be a recession? It would not have to be a particularly severe recession to send stocks lower from their 2022 endpoint. S&P 500 earnings have declined by an average of 29.5% in past recessions; while analyst earnings forecasts for 2023 have been revised downward over recent months, the consensus forecast is still a 4.4% year-over-year increase, according to an end-of-year report by Yardeni Research. Recessions and earnings growth—even mild growth—simply don’t go hand in hand, so if you believe a recession is likely to occur then you should expect stocks to decline.

There is a more optimistic case for markets in 2023, and it doesn’t feel like much of a stretch. First, inflation does appear to be declining. CPI has been declining since June when it peaked at a 9.1% year-over-year increase. November’s CPI, released in December, showed a 7.1% annual increase. November’s CPI was also the second month in a row when the actual release came in below the consensus expectation. This was something that hadn’t occurred at all in 2022 until October. Additionally, if one annualizes the month-over-month increases of CPI from July through November, which strips away the impact of lower 2021 comparisons faced by year-over-year data, inflation averaged 2.4% over the second half of 2022 (excluding December, data for which will be released in January). The softening inflation picture is a necessary condition for the “bull case” for markets in 2023 because without softening inflation the Fed will be forced to continue tightening and thus will only further put pressure on the economy and asset valuations.

Another cause for optimism is that the overall economy has been resilient in the face of these tighter monetary conditions. Granted, certain sectors, notably tech companies and housing have suffered. Technology stocks came into 2022 with soaring valuations that quickly got crushed; this led to household names like Amazon, Meta, Microsoft and more recently, Salesforce, announcing significant layoffs in an effort to trim costs. Within the housing sector, the rising interest rate environment was quickly effective in cooling off the home-buying frenzy of 2020-2021. As mortgage rates rose rapidly, homebuyers saw their budget shrink considerably if they weren’t priced out of the market altogether. There remains a drastic housing supply shortage that will likely keep U.S. housing tight for years to come, but much of the rampant speculation has been stripped from the market.

More broadly, though, the tongue-in-cheek refrain when one is at a restaurant, airport or shopping center is, “what recession?”. In the aggregate, consumers have continued to spend like we’re in a strong economy. One can draw a line directly between this consumption and the still-tight labor market. The unemployment rate in November remained at 3.7%-- historically low by any standard—and other data releases still show a much higher rate of job openings than job seekers. It should be encouraging to investors—not to mention the Fed—that inflation appears to be softening even though the labor market remains so strong.

Our year-end newsletter has been U.S.-focused thus far, but obviously, there are global flashpoints, known and unknown, that will drive markets in 2023. Will the Russia-Ukraine war come to some semblance of a resolution, or will the conflict enter a prolonged period of stalemate? With China’s end to its strict zero-covid policy, will we see that country and its economy ravaged by a new wave of infection, or will it represent a massive economic rebound like that seen around the world as other countries emerged from lockdown? Answers to these questions and other, heretofore unknown, global developments will drive global markets in 2023 and likely impact U.S. investors.

Whether you’re ultra-bearish or ultra-bullish, you probably need to moderate your outlook. The competing narratives and complex dynamic of this economic situation are exactly the reasons why investors should position their portfolios based on their time horizon, goals and risk tolerance rather than what they think is most likely to happen over the next 6-12 months. So much of long-term successful investing depends on managing emotional reactions, avoiding greed in good times and panic in bad times. This discipline is harder to maintain in environments like this, but this is also when it’s the most critical to do so.

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